China: Pausing for a breather (page 1 of 3)

Economic growth in 2003 was well above trend despite the attack of SARS, driven by rapid investment growth. With real GDP growth at 9.1%, many fear that the economy is overheating. As we have argued previously, China is facing an over-investment problem, rather than overheating in the broad economy. In fact, private consumption and exports still have room to grow before excess demand appears.

We expect China to slow moderately with GDP growth falling from 9.7% in the first half to 8% in the second half of 2004. Growth should then stabilize in 2005. The current slowdown in the economy would prepare China for another episode of rapid growth between 2006 and 2008. An investment and private consumption boom could emerge on the back of the 'feel-good' factor stemming from the Beijing Olympics in 2008 and the World Expo in Shanghai in 2010.

From euphoria to sensibility
Data in recent months suggest China is currently on the right track towards a managed slowdown in investment and in the monetary base. While there are concerns over whether such a slowdown could go too far in the next 12-18 months, foreign investors continue to cast their votes of confidence on China's longer term prospects as a production base and a consumer market. General Motors plans to spend $3bn in the next three years to expand its existing production capacity in China. Bayer Group is also planning to invest $1.8bn in China between 2004 and 2006. The amount represents almost half of the company's overseas investment budget. Tesco is buying a 50% stake in a local chain for $260mn. All this is indicative of the longer-term upward trend.

Contracted foreign direct investment (FDI) to utilised FDI can be used as a proxy for foreign investor sentiment. The rise or fall in the ratio indicates whether foreign investors are committing more capital to China, a reflection of investor sentiment. This ratio has been rising since 2003 with contracted FDI currently more than twice as much as actual FDI. Although the ratio seems to be topping out, partly due to the macroeconomic measures, it is still above trend. Foreign investors are no longer treating China as just a cheap manufacturing hub, but also a potentially huge consumer market and a growing pool of talent.

Heated debate over the cooling economy has encouraged both domestic and overseas investors to realign their China strategies more realistically. China is after all not exempt from the global economic cycle. Although headline growth may appear stable between 7% and 9%, various components of the economy are subjected to much greater volatility.

Rising FDI and slower investment can be compatible
Rising foreign direct investment flows at a time when the government is trying to decelerate fixed asset investment is not mutually exclusive. Firstly, FDI is only a small proportion of total investment in China. In 2003, FDI was only 8% of fixed asset investment. China is not short of capital. Yet the focus is on attracting the foreign technology, management skills and other operational know-how to improve competitiveness and productivity. Therefore the government will be happy to see the steady inflow of foreign capital.

Secondly, the Chinese authority is trying to weed out uncompetitive, low quality and duplicate investment. Broadly speaking, foreign projects are seen as higher quality as their feasibility is assessed through potential return and financial profit. The government's attempts to slow investment typically targets local, small and medium domestic enterprises that are involved in over-invested sectors.